September 9 1997: US economy: Brave new world?

News

US economy: Brave new world?
TUESDAY SEPTEMBER 9 1997
By Gerard Baker
Board an airline anywhere in the US these days and you get an idea of the buzzing dynamism of the US economy in the late 1990s. Every plane, from San Jose to Savannah and points in between, is full to bursting. The busy bleep and click of laptop computers and mobile phones seems to drown out the whining of the aircraft engines as America goes to work with a rare vigour.

The aerial activity reflects the fact that, on the ground, the US is enjoying its most remarkable period of economic success since before the Vietnam war. Unemployment is lower than it has been in a generation; output is growing at its fastest rate in a decade; incomes, for so long depressed by global competition, are at last rising strongly. All this at the same time as, uniquely in the last quarter- century, inflation is dormant.

The hum of success is all the more melodious in comparison with the groan of stagnation from the rest of the industrialised world. In continental Europe and Japan recovery of a sort continues - but joyless, jobless recoveries that have done little to revive economic optimism.

Small wonder then that more and more US businessmen and economists have signed up to the view that their economy has been transformed. How else could it be, they ask, that the US is able to manage sustained strong growth with such a low level of unemployment and yet without a hint of inflation? The answer, they claim, is that a unique concurrence of events has raised long-term US potential growth, enabling the economy to grow faster without stoking inflation.

"The underlying economic environment is exceptional," says Bruce Steinberg, chief economist at Merrill Lynch, the New York investment bank. "Growth is healthy, inflation is invisible, corporate earnings are strong and real wages are rising. All without any noticeable strain." "It is indeed a 'New World'," says Allen Sinai, chief economist with Primark Decision Economics and one of the leading Wall Street economists. "And it is not just a cyclical phenomenon, but the result of a radical change."

For the past 25 years it has been accepted as virtually immutable law by almost all economists and policymakers that the US economy had a speed limit of about 2.25-2.5 per cent annual growth, and a floor for unemployment of about 5.5-6 per cent.

Whenever the annual growth rate rose above 2.3 per cent for a long time, or whenever unemployment fell below 5.5 per cent, wages and prices began to spiral upwards. The economy's capacity to grow is limited by growth in the labour force and in productivity. When demand grew faster than the sum of these rates, inflationary bottlenecks occurred.

But consider this: since the beginning of 1996, the economy has expanded at an annual rate of 3.5 per cent per year. Unemployment has fallen from 5.8 per cent 18 months ago to 4.9 per cent today. At the same time, however, inflation has not only not risen. It has actually drifted lower: the consumer price index is rising at about 2.3 per cent per year, compared with 2.6 per cent at the beginning of 1996. Further back up the inflationary pipeline, price pressures are even weaker: the producer price index fell for six months in a row at the start of this year.

That can only be explained, it is argued, if the underlying non- inflationary capacity of the economy has improved - so that output can grow much faster than the old 2.3 per cent speed limit, and unemployment can remain below 5.5 per cent a year, while inflation stays under control.

This is not a dry academic argument among economists. It is the very assumption on which is predicated the spectacular growth of the US stock market in the last two years. If the economy can grow significantly faster than in the past without inflation it means two things: corporate earnings (which largely track output growth over time) can grow faster, while interest rates (which determine the relative attractiveness of holding equities against bonds) can be expected to remain low.

"Structural changes that have occurred in the 1990s have raised the long-run potential growth rate, we estimate to as much as 3 per cent per year," says Mr Sinai.

This is a popular view in the financial markets. Its supporters say the reason for the change is a complex combination of favourable factors. These include such diverse developments as the end of the cold war, which has freed up public and private sector resources for more productive use; years of fiscal restraint - the budget deficit has fallen from 5 per cent of gross domestic product at the start of the decade to almost zero today, reducing long-term interest rates and bolstering investment; and monetary stability, which has forced companies to control their costs in order to stay competitive.

But most people point to two big changes as the main reasons for the revolution:

The growing globalisation of US business has limited American companies' freedom to raise prices, forcing them to become more competitive;

Even more important, massive investment in information technology is said, without hyperbole, to have represented a new industrial revolution that has raised productivity, and the economy's potential growth rate.

This so-called "New Age" thesis received support from a surprising source in July when Alan Greenspan, chairman of the Federal Reserve, in his half-yearly testimony to the US Congress, left open the possibility that something radical might have changed in the US.

"We do not now know, nor do I suspect can anyone know, whether current developments are part of a once or twice in a century phenomenon that will carry productivity trends . . . to a higher track, or whether we are merely observing some unusual variations within the context of an otherwise generally conventional business cycle expansion," he said.

The Fed chairman's remarks were characteristically equivocal, however, and in the view of most mainstream academic economists they were right to be. There are serious problems with both the main arguments for the New Age.

First, there is little firm evidence to support the claim that globalisation has been all that significant for US companies. Even if it had been, it is hard to see how it spells the end of inflation.

Paul Krugman, professor of economics at Massachusetts Institute of Technology, points out that trade still accounts for less than 30 per cent of GDP. So even if the US were importing some sort of magic formula, the spell would be less effective in the US than in most other countries. And the experience of other countries that are much more open to international trade than the US does not suggest globalisation alone can lift the potential growth rate.

"The UK is by any measures at least twice as open to trade as the US," says Prof Krugman. "But there is no evidence there to support claims that globalisation is inherently anti-inflationary."

Second, in spite of all the anecdotal claims, there has been no clear sign of a sharp, permanent upward shift in productivity. The official statistics suggest little change in productivity trends. New Age believers point to flaws in these statistics that have failed to pick up improvements in service sector productivity. But, even if they are are right and the data are indeed under-estimating productivity growth, then the figures must also be understating actual output growth, since they rely on precisely the same measures. And if output is also underestimated, it means the inflationary gap between potential and actual output is just as large. This cannot explain the absence of inflation in a period of rapid growth.

In any case, the faster rate of growth seen in recent years can be easily explained by the fall in the unemployment rate. Higher output has been the result of more hours worked by more workers, not an increase in the amount of output produced per hour.

But that still leaves the original question unanswered: why does the US now have high growth with low unemployment and low inflation? There are two possible explanations: time lags and demographic changes.

For all the talk of a 1990's US "miracle", growth for much of this decade has actually been far from miraculous. From the end of the previous recession in 1991 to the beginning of last year, growth averaged less than 2.3 per cent a year. That was below the long-term trend of 2.25-2.5 per cent. There has been an acceleration in growth since then, but only in the past 18 months. It is simply too early to say with confidence that faster growth will not feed through into higher inflation. All that may be happening is that the time lag (usually six to 12 months) is slightly longer than usual.(the normal lag is up to a year).

So might something else explain the fact that an unemployment rate below 5 per cent co-exists with an inflation rate consistently below 3 per cent? The answer is yes: the notion of an economy in transition.

Demographic changes may have made it possible for unemployment to fall without pushing up inflation. One example is the age-profile of the workforce. With a smaller proportion of young workers in the population, it is possible workers change jobs less frequently - and that enables employers to hold wages somewhat lower than they might otherwise have done, because they do not have to pay a premium to hold on to workers.

"What we have is encouraging evidence over the last few years that the economy may be able to operate at a higher level of capacity use and a lower level of unemployment, with lower levels of inflation," says Larry Summers, the deputy treasury secretary.

If so, this would mark progress. But it would hardly be the revolutionary and permanent increase in the growth rate claimed by the New Agers. Rather, after a transition period that long-term trend rate would revert to its old level, and any growth above that level would still prove inflationary.

As Mr Greenspan himself put it in an earlier testimony before the congress this year: "Regrettably, history is strewn with the visions of such 'new eras' that, in the end, have proven to be a mirage. In short, history counsels caution."

© Copyright the Financial Times Limited 1997
"FT" and "Financial Times" are trademarks of The Financial Times Limited.

		US economy: Brave new world? TUESDAY SEPTEMBER 9 1997 By Gerard Baker Board an airline anywhere in the US these days and you get an idea of the buzzing dynamism of the US economy in the late 1990s. Every plane, from San Jose to Savannah and points in between, is full to bursting. The busy bleep and click of laptop computers and mobile phones seems to drown out the whining of the aircraft engines as America goes to work with a rare vigour. The aerial activity reflects the fact that, on the ground, the US is enjoying its most remarkable period of economic success since before the Vietnam war. Unemployment is lower than it has been in a generation; output is growing at its fastest rate in a decade; incomes, for so long depressed by global competition, are at last rising strongly. All this at the same time as, uniquely in the last quarter- century, inflation is dormant. The hum of success is all the more melodious in comparison with the groan of stagnation from the rest of the industrialised world. In continental Europe and Japan recovery of a sort continues - but joyless, jobless recoveries that have done little to revive economic optimism. Small wonder then that more and more US businessmen and economists have signed up to the view that their economy has been transformed. How else could it be, they ask, that the US is able to manage sustained strong growth with such a low level of unemployment and yet without a hint of inflation? The answer, they claim, is that a unique concurrence of events has raised long-term US potential growth, enabling the economy to grow faster without stoking inflation. "The underlying economic environment is exceptional," says Bruce Steinberg, chief economist at Merrill Lynch, the New York investment bank. "Growth is healthy, inflation is invisible, corporate earnings are strong and real wages are rising. All without any noticeable strain." "It is indeed a 'New World'," says Allen Sinai, chief economist with Primark Decision Economics and one of the leading Wall Street economists. "And it is not just a cyclical phenomenon, but the result of a radical change." For the past 25 years it has been accepted as virtually immutable law by almost all economists and policymakers that the US economy had a speed limit of about 2.25-2.5 per cent annual growth, and a floor for unemployment of about 5.5-6 per cent. Whenever the annual growth rate rose above 2.3 per cent for a long time, or whenever unemployment fell below 5.5 per cent, wages and prices began to spiral upwards. The economy's capacity to grow is limited by growth in the labour force and in productivity. When demand grew faster than the sum of these rates, inflationary bottlenecks occurred. But consider this: since the beginning of 1996, the economy has expanded at an annual rate of 3.5 per cent per year. Unemployment has fallen from 5.8 per cent 18 months ago to 4.9 per cent today. At the same time, however, inflation has not only not risen. It has actually drifted lower: the consumer price index is rising at about 2.3 per cent per year, compared with 2.6 per cent at the beginning of 1996. Further back up the inflationary pipeline, price pressures are even weaker: the producer price index fell for six months in a row at the start of this year. That can only be explained, it is argued, if the underlying non- inflationary capacity of the economy has improved - so that output can grow much faster than the old 2.3 per cent speed limit, and unemployment can remain below 5.5 per cent a year, while inflation stays under control. This is not a dry academic argument among economists. It is the very assumption on which is predicated the spectacular growth of the US stock market in the last two years. If the economy can grow significantly faster than in the past without inflation it means two things: corporate earnings (which largely track output growth over time) can grow faster, while interest rates (which determine the relative attractiveness of holding equities against bonds) can be expected to remain low. "Structural changes that have occurred in the 1990s have raised the long-run potential growth rate, we estimate to as much as 3 per cent per year," says Mr Sinai. This is a popular view in the financial markets. Its supporters say the reason for the change is a complex combination of favourable factors. These include such diverse developments as the end of the cold war, which has freed up public and private sector resources for more productive use; years of fiscal restraint - the budget deficit has fallen from 5 per cent of gross domestic product at the start of the decade to almost zero today, reducing long-term interest rates and bolstering investment; and monetary stability, which has forced companies to control their costs in order to stay competitive. But most people point to two big changes as the main reasons for the revolution: The growing globalisation of US business has limited American companies' freedom to raise prices, forcing them to become more competitive; Even more important, massive investment in information technology is said, without hyperbole, to have represented a new industrial revolution that has raised productivity, and the economy's potential growth rate. This so-called "New Age" thesis received support from a surprising source in July when Alan Greenspan, chairman of the Federal Reserve, in his half-yearly testimony to the US Congress, left open the possibility that something radical might have changed in the US. "We do not now know, nor do I suspect can anyone know, whether current developments are part of a once or twice in a century phenomenon that will carry productivity trends . . . to a higher track, or whether we are merely observing some unusual variations within the context of an otherwise generally conventional business cycle expansion," he said. The Fed chairman's remarks were characteristically equivocal, however, and in the view of most mainstream academic economists they were right to be. There are serious problems with both the main arguments for the New Age. First, there is little firm evidence to support the claim that globalisation has been all that significant for US companies. Even if it had been, it is hard to see how it spells the end of inflation. Paul Krugman, professor of economics at Massachusetts Institute of Technology, points out that trade still accounts for less than 30 per cent of GDP. So even if the US were importing some sort of magic formula, the spell would be less effective in the US than in most other countries. And the experience of other countries that are much more open to international trade than the US does not suggest globalisation alone can lift the potential growth rate. "The UK is by any measures at least twice as open to trade as the US," says Prof Krugman. "But there is no evidence there to support claims that globalisation is inherently anti-inflationary." Second, in spite of all the anecdotal claims, there has been no clear sign of a sharp, permanent upward shift in productivity. The official statistics suggest little change in productivity trends. New Age believers point to flaws in these statistics that have failed to pick up improvements in service sector productivity. But, even if they are are right and the data are indeed under-estimating productivity growth, then the figures must also be understating actual output growth, since they rely on precisely the same measures. And if output is also underestimated, it means the inflationary gap between potential and actual output is just as large. This cannot explain the absence of inflation in a period of rapid growth. In any case, the faster rate of growth seen in recent years can be easily explained by the fall in the unemployment rate. Higher output has been the result of more hours worked by more workers, not an increase in the amount of output produced per hour. But that still leaves the original question unanswered: why does the US now have high growth with low unemployment and low inflation? There are two possible explanations: time lags and demographic changes. For all the talk of a 1990's US "miracle", growth for much of this decade has actually been far from miraculous. From the end of the previous recession in 1991 to the beginning of last year, growth averaged less than 2.3 per cent a year. That was below the long-term trend of 2.25-2.5 per cent. There has been an acceleration in growth since then, but only in the past 18 months. It is simply too early to say with confidence that faster growth will not feed through into higher inflation. All that may be happening is that the time lag (usually six to 12 months) is slightly longer than usual.(the normal lag is up to a year). So might something else explain the fact that an unemployment rate below 5 per cent co-exists with an inflation rate consistently below 3 per cent? The answer is yes: the notion of an economy in transition. Demographic changes may have made it possible for unemployment to fall without pushing up inflation. One example is the age-profile of the workforce. With a smaller proportion of young workers in the population, it is possible workers change jobs less frequently - and that enables employers to hold wages somewhat lower than they might otherwise have done, because they do not have to pay a premium to hold on to workers. "What we have is encouraging evidence over the last few years that the economy may be able to operate at a higher level of capacity use and a lower level of unemployment, with lower levels of inflation," says Larry Summers, the deputy treasury secretary. If so, this would mark progress. But it would hardly be the revolutionary and permanent increase in the growth rate claimed by the New Agers. Rather, after a transition period that long-term trend rate would revert to its old level, and any growth above that level would still prove inflationary. As Mr Greenspan himself put it in an earlier testimony before the congress this year: "Regrettably, history is strewn with the visions of such 'new eras' that, in the end, have proven to be a mirage. In short, history counsels caution."


		© Copyright the Financial Times Limited 1997 "FT" and "Financial Times" are trademarks of The Financial Times Limited.